Category: 2019

Happy Holidays to all our subscribers. Thank you for your support throughout our first half year – we greatly appreciate it and wish you many happy returns in the New Year. Hopefully we can help with some of those financial goals (but keeping the New Year gym membership resolution is not our responsibility). We encourage you to review our website, and follow us on Instagram and Twitter, where we share more regular bite-sized commentary.

Buckle up. This is an end of year special. The structure of this newsletter: 

1. Performance figures
2. Podcast with Frazis Capital
3. What went wrong this past half year at Insufficient Capital 
4. What went right this past half year at Insufficient Capital
5. Stock focuses on Afterpay (APT:ASX) and Acrow Formwork (ACF:ASX)
6. 5 stocks on our 2020 watchlist (we will provide details on 5 more watchlist stocks in the next newsletter)

Performance Figures

At the end of the December quarter, the fund was most heavily weighted to our ‘Structural Tailwinds’ strategy. ‘Structural Tailwinds’ refers to areas of the economy which are growing at a faster rate than the national average growth rate. Afterpay is our largest holding:

The portfolio rose +2.65% over the quarter, outperforming the ASX300 performance of -0.03% by +2.68%. The top contributor during the quarter was Acrow Formwork (ACF:ASX) while the largest detractor was Stanmore Coal (SMR:ASX). The top contributor during December was Stanmore Coal (SMR:ASX), while the largest detractor was Afterpay (APT:ASX). The fund currently holds 21% cash.

It was very pleasing to report outperformance of +10.93% over the half year, with outperformance over all months but October. This puts the portfolio well on track to achieve its outperformance target of +10%/annum above the ASX300. The cash position held over the half year averaged 22% while the position in gold (typically defensive) averaged 10%. Outperformance has been achieved through this relatively conservative exposure. The majority of our portfolio holdings have net cash on their balance sheets, ensuring the overall portfolio remains financially secure and nimble. This is particularly important during the current seemingly never-ending bull market, where the cost of domestic credit continues to break record lows. The fund continues to keep an eye on, but remains relatively indifferent to, macroeconomic conditions. 

Put simply, we find businesses that we like, and we buy them throughout the cycle. 

As far as the peak of the business cycle is concerned, Warren Buffett addresses the matter far better than we could:

“In the 20th Century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow (Jones Index) rose from 66 (points) to 11497 (points).”

Podcast with Frazis Capital

We recently thoroughly enjoyed recording a podcast with Frazis Capital Partners. Check out Part 1 (Part 2 will be in the next newsletter) of the discussion on growth opportunities and the software sell-off on desktop here and on iTunes here. Frazis Capital invests in a high conviction global portfolio focused on technology and the life sciences. The fund is one of the few investment vehicles in Australia focusing entirely on technology and the life sciences. Many value managers actively avoid these sectors. Michael (portfolio manager) has a deep understanding of the intricacies of the life sciences, having read chemistry at Oxford. Unlike Insufficient Capital, Frazis Capital is open for investment. The fund has posted a very strong performance of +29% this calendar year to date (as of 30 November).

What Went Wrong this Half Year at Insufficient Capital

Despite the significant outperformance recorded, there were a couple of disappointing outcomes throughout the half year. The largest stock-specific mistake concerned our largest position at the start of the half year, Stanmore Coal (SMR:ASX). There is always commodity price risk in miners. We entered the position, attracted by Stanmore’s strong margins, cashed up balance sheet (no debt), higher quality product, experienced management and project pipeline, concluding that the company could weather a coking coal price downturn.

The coking coal price has collapsed from a peak of $200/tonne in May 2019 to $140/tonne today:

Despite the price fall effectively halving Stanmore’s profit margin, the stock was supported well into September by a prospective buyout proposal from Winfield Group Investments for $1.50-$1.70/share. 

We formed the opinion that despite the falling coking coal price, other bidders were likely to emerge, attracted to the firm’s vast free cashflows and deleveraged balance sheet. Less than a year ago, Stanmore had received a buyout offer from Golden Investments, a potential rival bidder against Winfield. 

Stanmore Coal Equity:

At its peak, with the offer still in play, Stanmore had expanded to over 20% of the fund’s assets. Internally, we have a target valuation of around $1.90/share, with a belief that Stanmore is undervalued (a 40% discount to its larger peers) considering its high quality coking coal (rather than thermal coal) assets and net cash balance sheet. 

In short, the buyout fell through because the other major shareholders refused to cooperate (M Resources and Golden Investments) and no further bids were received. The stock corrected >30% to adjust for the lower coking coal price, costing us >6%. In hindsight, despite the fund’s internal valuation of $1.90/share, the position should have been halved to a circa 10% weighting. $1.50-$1.70 was the offer on the table and Insufficient Capital is not in the business of merger arbitrage. Lesson Learnt. 

A firm pillar of the Insufficient Capital investment methodology is buying and holding investments, effectively letting the market rebalance the portfolio over time (provided the investment thesis remains unchanged). For example, a portfolio of 10 stocks bought today with a 10% weighting in each stock, will have vastly different weightings if no changes are made over the ensuing 2-5 years. After such an extended period of time, it is quite likely that the largest 3 holdings account for over 60% of net assets, while the smallest 3 account for less than 15%. Our philosophy had not been tested by a prospective buyout. We were offered a multi-week opportunity to exit at an M&A elevated valuation after the coal price had collapsed… the benefits of hindsight.

It is now back to business as usual. Stanmore will likely generate over $100M of EBITDA this financial year and EPS of circa $0.25, with earnings supported by continued global stimulus driving steel-making across Asia. The market values Stanmore at a forward PE of 4X and EV/EBITDA of 1.6X. The firm continues to trade at a 40% discount to a basket of its peers despite its superior quality coal and substantial cash position. The main reasoning behind the ‘Net Cash Miners’ strategy is continual investment throughout the cycle (particularly when commodity prices are depressed) and resilience to the threats of cyclical downturns. Cash also facilitates asset purchases at heavily depressed valuations. It is important to remember that Stanmore transformed a $1 asset purchase (when coking coal prices were low in 2015) into a $300M company.

The other key mistake made during the half year concerned general issues around position sizing. As described above, setting and forgetting a portfolio for a long period will always show a portfolio manager which companies are performing well because “In the short run, the market is a voting machine but in the long run, it is a weighing machine” (Benjamin Graham). Going forward, we will be much stricter on initiating every new position at a similar size (weighted relative to risk), resisting the urge to add to positions or transact without high conviction. At the moment, Insufficient Capital transacts around twice per month (this is quite low but could be decreased considering our ‘buy and hold’ mentality). 

What Went Right this Half Year at Insufficient Capital

Consolidating the fund’s overall strategy in April has been successful thus far. Paying a fair price for great core businesses through fundamental analysis has been the key to success. Analysing businesses’ future cashflows and future cashflows alone is what we do best. All other methods of valuation are background noise.

The top three contributors which account for approximately all of the fund’s performance over the half year are: 

• EML Payments (+6.5%)
• Afterpay (+3.6%) 
• Pointsbet (+2.5%)

Whilst a high level of consolidation amongst performance contributors is expected for a high conviction portfolio, underperforming holdings in the portfolio must have their time in the sun. This is the only way to sustain long term outperformance without high volatility since outperforming holdings which continue to outperform will increase in portfolio weighting, and thus, potential drawdown. We believe that Acrow Formwork (see further analysis below) will be the most likely outperformer out of the fund’s previously underperforming holdings.

Stock Focus: Afterpay (APT:ASX)

Afterpay is one of the most widely discussed stocks on the Australian market. In fact, the fund’s sources reveal that it has become very topical amongst US investment circles (particularly after US technology fund, Coatue Management, invested $200M in November). It is difficult to add a different perspective to Afterpay but hopefully the commentary below adds value to the overall picture. Some of our prior commentary on Afterpay can be found in the August newsletter.

The fund believes this is an excellent time to own Afterpay stock, with exponentially increasing spend/customer and superb execution in the US, where the overall customer count is now comparable to Australia. The August newsletter highlighted the relationship between domestic purchasing frequency and time since joining Afterpay. This year’s annual results (reported 28 August) revealed that customers for 3+ years purchased through Afterpay around 20X/annum, 2+ years around 10X/annum and 1+ years around 4X/annum. Those customer cohorts now respectively spend 22X/annum, 14X/annum and 7X/annum.

It is important to remember that nearly all of the circa 3 million US customers fall into the 7X/annum category (along with the >500K UK customers added since launch 8 months ago). If the overseas customers follow Australian consumer behaviour, total purchases across the entire business could more than double over the next 2 years. That is without any further customer acquisition or increased domestic purchasing frequency.

Afterpay is currently trading at around 15X forward EV/Sales, towards the lower end of its historical trading range (however, as described above, we place little value on historical trading ranges). In the past, Afterpay has traded between 10X forward EV/Sales and 30X forward EV/Sales (30X usually prior to the announcement of annual results in August). By the end of this financial year (June 30, 2020), Afterpay will be far more established in the US and UK. Strong underlying sales growth is again expected over this financial year (underlying sales grew +140% last financial year), driven by customer growth in the US and UK along with increases in spend/customer across all markets… the black revenue line should significantly leg up again come next year:

November’s sales figures boded very well for FY2020 revenue, driven by record sales on Black Friday and Cyber Monday. The $1B of sales processed by Afterpay was a monthly record for the company. Sales of $160M over Black Friday and Cyber Monday were up +160% compared to last year. Afterpay also attracted over 140,000 new customers over the 2 days. The business is on track to process over $9B of sales this financial year (FY2019 recorded $5.2B of sales).

Gross Merchandise Volume (GMV – effectively equivalent to total underlying sales for Afterpay) and the company’s market capitalisation have both increased significantly over the last 2 years:

We have tracked interesting measures for Afterpay’s development: Instagram follower growth, google trends data and iOS app ratings. The graph below illustrates the growth of the google search term, “Afterpay”, compared to its 3 largest US competitors. Afterpay is clearly gaining superb traction in the US, with google search frequency increasing about 5X over the last 12 months:

Despite the stock appreciating over 5X since our first entry, we have never been more excited about Afterpay’s future prospects. We are confident that it will still be our largest holding at the end of the financial year. 

Stock Focus: Acrow Formwork (ACF:ASX)

Acrow Formwork is typical of Insufficient Capital’s ‘Deep Value’ strategy. The companies in this category are unloved, often relatively unknown operating businesses that produce strong cashflows. The thesis behind Insufficient Capital’s initial investment in Acrow can be found in an earlier newsletter. 

Acrow’s acquisition of Uni-span (a Queensland formwork, industrial scaffolding and labour hire company) for $21.25M (4.4X FY19 EBITDA) is a game-changer for the little-known $70M microcap. Uni-span primarily serves the typically defensive civil infrastructure market. The acquisition immediately adds 22% to EPS (from 4.36cps to 5.31cps) before any potential synergies are realised. 

Potential synergies include revenue synergies from complementary products and services, as well as integration synergies with regard to yard consolidation, staff and other general expenses. Such synergies support earnings growth over the mid-term. With the business trading at 6.7X forward PE and 4.6X forward EBITDA, there is not a lot of growth priced in. The new consolidated group has already experienced early success with a 6-9 month $2.75M contract to provide formwork propping solutions for Sun Metals Zinc Refinery.

A particularly exciting part of Uni-span is its exclusive arrangement with ULMA (a leading Spanish manufacturer and supplier of formwork, shoring and temporary scaffolding systems). The newly consolidated firm recently signed a 3 year contract extension with ULMA, which now includes product distribution in New Zealand. Steve Boland, CEO of Acrow, stated that “We are encouraged by the similar dynamics being experienced in the New Zealand civil infrastructure construction market as those experienced in the Australian market at present. Early indications suggest that the marketing and supply of Acrow/ULMA formwork products into New Zealand will be well received by the market.” Uni-span also has a specific style of equipment which is key to tunneling-style work, further expanding the product offering of the combined business. 

Acrow financed the acquisition with its Westpac facility, maintaining relatively conservative gearing of 34% net debt/equity.

In 2012, Warren Buffett purchased a WA crane company. In 2017, the company generated $6.15M of profit on revenues of $150M. It was a classic old-school Buffett investment… a founder-led, capital intensive, reliably profitable firm. Other construction companies owned by Berkshire Hathaway include: Acme Brick Company, Benjamin Moore and Co, Cavalier Homes, Clayton Homes, International Metalworking Companies, Johns Manville and Shaw Industries. Such businesses are not particularly glamorous but have relatively reliable cashflows and are easily valued on traditional metrics.

Insufficient Capital values Acrow Formwork at 7X forward EV/EBITDA (50% above the firm’s current valuation) based on discounted cash flow analysis and peer comparison.

5 Businesses on our CY2020 Watchlist

STOCK	WHY WE’RE WATCHING
Bapcor (BAP:ASX)	Australasia’s largest aftermarket auto supplier/service provider (parts, accessories, equipment) with steady revenue, profit and dividend growth across its umbrella of brands. 5 year CAGR: Revenue +36% NPAT +42%, EPS +25%, DPS +18% Expansion to Asia (currently 5 Burson Auto Parts stores in Thailand) gives Bapcor access to far larger markets with the hope of replicating Australian success. At 18.1x consensus forward PE and 12x forward EV/EBITDA, the business is attractive if high single-digit growth can be achieved despite the underlying low economic growth environment.
Carvana (CVNA:NYSE)	Sells used cars online and provides finance for them. This means that they don’t have the typical costs and overheads of a traditional dealership. Cars are then delivered to your door. i.e. lower cost of doing business and more consumer friendly than traditional dealerships. Business has grown revenue organically at >100% pa but remains loss-making for now. Currently 0.4% market share in a highly fragmented market (with no single firm holding more than 5% of the market). If the business continues to demonstrate its value to consumers, market share could significantly expand.
Sandfire Resources (SFR:ASX)	Copper-gold producer valued attractively at a compelling EV/EBITDA of 2.5x with a strong net cash balance (about 25% of market capitalisation). We believe market has placed too much emphasis on its short mine life (~3 years) at its flagship DeGrussa project. SFR has made numerous investments in junior explorers, and a recent acquisition of MOD Resources, which we think should provide adequate project pipeline. That said, we need to be convinced of management’s ability to allocate capital before making an investment.
Synlait Milk (SM1:ASX)	With strong ties to A2 Milk (A2M), SM1 develops its assets to deliver quality New Zealand dairy products, with a particular focus on the high growth infant formula market.    Exclusive supply rights to A2M, 5 year minimum supply agreement signed in 2018, A2M owns 17.4% of SM1.   Question marks surrounding the longevity of SE Asian demand for Australian infant formula and dairy products, particularly after the Chinese acquisition of Bellamy’s in September.    17.2X forward PE and 10.1X forward EV/EBITDA with low double digit earnings growth is very attractive.
Xero (XRO:ASX)	We were most attracted to XRO when we first bought Afterpay in late 2017. At the time, we believed we had enough exposure to unprofitable high growth firms in the portfolio. 2 years have passed and we clearly made the wrong decision (the company’s valuation has nearly tripled).   XRO’s simple accounting software continues to successfully expand across the US and UK, with ever-increasing economies of scale (as is typical of SAAS businesses). It is a high quality, net cash business, benefiting from the broader move towards accounting simplification.   At a consensus 2021 PE of 180X and EV/EBITDA of 55X with top line growth of circa +35% and earnings growth around +60%, we believe XRO will do well but struggle to see a continuation of past returns with the possibility of valuation multiple compression… famous last words.

We hope to record strong performance throughout the second half of the Australian financial year and look forward to keeping our subscribers updated. The founder has their entire net worth invested in this strategy. If you would like further details regarding our activities, we are always happy to discuss portfolio positions. 

Best Wishes for 2020 and a very Happy New Year.

Welcome to the first monthly newsletter for “Insufficient Capital”, the name applied to a long-only equities portfolio. The name applied to the fund is a self-deprecating jab at the fund’s relatively small pool of capital. The newsletters aim to analyse the portfolio as well as general market/economic conditions.

About the Portfolio Manager

The portfolio manager is studying a degree in Civil Engineering (Hons) and Commerce (Finance) at UNSW. Some of the harsh lessons learnt through past investments manifest in the “Ground Rules” available here.

During the month of April, Insufficient Capital appreciated +8.56% compared to the ASX300 Performance of +2.43%. The rationality behind benchmarking against the ASX300 will be explained at the end of this newsletter. The greatest performance contributor was Starpharma Holdings (SPL:ASX) while the largest detractor was Aurelia Metals (AMI:ASX).

As the first monthly newsletter, it is pertinent to set up the Ground Rules for the fund, the disclaimer being that the fund reserves the right to break the rules in special circumstances. Any amendment to the Ground Rules will be noted in future letters.

Our Ground Rules are available here.

These letters will discuss specific stocks, typically portfolio positions, and topics relevant to investing. When investing, nearly all learnings occur when money is lost so it is fitting in this first newsletter to discuss the largest monthly detractor: Aurelia Metals.

Aurelia Metals

Aurelia fell around 16% during the month, primarily due to a disappointing quarterly result. Gold production of 23,323oz was down due to the underperformance of gold grades (less gold was in the ore mined than expected) while the all-in sustaining cost (AISC) was $1302/oz, up significantly from $733/oz recorded last quarter. However, the gold price achieved of $1821/oz demonstrates the significant margin Aurelia has as one of the lowest cost Australian gold producers. Cash conversion was strong, with Aurelia’s quarterly sales revenue of $67m resulting in net site operating cashflow of $25.6m. Net cash increased marginally from $107.9m to $108.6m. Although underwhelming, Aurelia is taking the measures required to continue doing what it does best – low cost gold production.

Concerns have been raised over Aurelia’s mine life, dampening the EV/EBITDA multiple applied to the company. The company’s Hera asset has a mine life of 4 years and contains 7 ore bodies. The current program for the asset is focused on near term drilling. After Hera, Aurelia will begin mining Nymagee which also has a life of 4 years. Aurelia’s Great Cobar asset has a potential mine life of 6 years and will add significant resources and reserves. Aurelia’s strong free cashflow from operations will likely enable it to fund Nymagee and Great Cobar without taking on debt.

A note on Aurelia’s hedging

In the past, hedging was required by lenders. The company’s healthy balance sheet has allowed hedging to run off, leaving the firm more exposed to movements in the gold price. When prices are above $1600-$1700/oz, Aurelia has stated they will hedge up to 50% of their gold production. This was reiterated on a private call the portfolio manager had with the CFO.

Why does Insufficient Capital hold Aurelia?

Insufficient Capital has a pessimistic outlook for the Australian economy over the short-to-midterm due to persistent levels of household debt (190% debt to income ratio is now the highest in the world), the increasing cost of credit impacting consumer spending and the wealth effect of falling house prices in Australia’s two major urban centres. It should be noted that Australia recently fell into a per capita recession for the first time since 2006, meaning that the economy relied on population growth to support the economy.

Gold is famously a poor long-term investment but performs well during challenging times and volatility due to its underlying value. Investment in a low cost gold miner like Aurelia effectively combines two hedges:

1. Gold as a store of value
2. Owning a business with high free cashflow from operations and a strong balance sheet (See Ground Rules 1 and 4)

Aurelia is valued at a favourable consensus forward EV/EBITDA multiple of 2.8X for the year ending June 30 2019. This compares to a global peer average of 9.4X (seekingalpha). If Aurelia continues to increase its cash balance rather than engage in capital expenditure, its EV/EBITDA multiple would likely continue to fall. It is significant to note Aurelia’s low EBITDA multiple despite a 3350% valuation gain since 2015 – debt-financing works wonders.

Aurelia recently disclosed it is in preliminary discussions regarding the potential acquisition of CSA Mines (a copper mine also in the Cobar region) from Glencore. The fund believes that this is an exciting earnings-accretive opportunity and efficient use of Aurelia’s substantial cash position.

Aurelia has made an astounding transition from carrying significant levels of debt to net cash within 4 years. This has led some to believe that new investors are late to the party. The fund does not believe the expected return is as high as it was in FY15, but the risk profile is now lower.

Benchmarking against the ASX300

Insufficient Capital will be benchmarking performance against the ASX300 index because there will be a strong portfolio weighting towards its constituents. Most companies with strong balance sheets and low leverage are towards the bigger end of town. Sometimes the fund will find companies which have lower capitalisations that are viable investments if they meet the criteria outlined in the Ground Rules (for example, Acrow Formwork – ACF:ASX). These will often be traditional operating businesses in retail, construction and broader industrials.

During the month, Warren Buffet’s perhaps most famous adage strongly resonated:

“Be Fearful when Others are Greedy and Greedy when Others are Fearful.”

This rings true for both the largest contributor and detractor for the month. Investments trading off fear often generate the greatest alpha opportunities. In this month’s positive case, the contrarian view is that Stanmore Coal offers great value with fears that coal has peaked pushing EV/EBITDA multiples very low. On the flip side, when staring into the abyss (for Insufficient Capital, this takes the form of a large red number), it is pertinent to recall the thesis behind the investment and remind oneself that the market is often irrational in the short term but a great weighing machine in the long term.

We look forward to future correspondence and would appreciate any constructive criticism going forward.

Yours Truly,

Insufficient Capital

Insufficient Capital fell 5.67% over April, compared to the ASX300 gain of 1.18%. The top contributor was Stanmore Coal, while the largest detractor was Aurelia Metals. On a rolling 12-month basis, Insufficient Capital has significantly outperformed the ASX300.

Acrow Formwork and Scaffolding (ACF:ASX)

During May, Insufficient Capital entered a substantial position in Acrow. Despite sitting well outside our preferred investment field of the ASX300 (market capitalization is $56m), the firm satisfies our investing Ground Rules* and we believe it will be a long-term compounder for the fund. Acrow has seven locations Australia-wide and employs around 150 staff. Although Acrow was a terrible performer this month, we never profess an ability to pick the bottom in individual stocks. We prefer to spend time in good companies rather than attempt to time them.

Acrow has a strong focus on civil infrastructure projects such as the Harwood Bridge upgrade over the Clarence river (Client: NSW & Federal Governments) and the Civic Centre Flytower Façade Refurbishment (Client: City of Mount Gambier). With its focus on infrastructure, Acrow’s revenue is highly defensive and the company can grow countercyclically as infrastructure spending increases to stimulate the economy during downturns. We are excited about Acrow’s prospects due to a plethora of both state and federal election infrastructure commitments following recent elections:

Residential Construction Fears
It is difficult to find an Australian monthly investment newsletter which does not touch upon the woes of domestic residential construction. Residential construction work has declined 17.7% from its peak in mid-2016 (Business Insider). This could have explained why Acrow has fallen 40% over the last 6 months until we took a look at the proportion of Acrow’s revenue derived from residential construction.

In fact, only 12% of Acrow’s revenue is linked to residential construction. Furthermore, revenue derived from residential construction grew from $3.7m in 2HY18 to $4.2m in 1HY19. At Insufficient Capital, we are always grateful for fear (in this case, regarding residential construction) because of the opportunities that often arise from it.

Natform
Natform was acquired by Acrow effective September 1, 2018 for around 2X trailing 12 month EBITDA of $3.8m. Management is pleased with the integration. It is clear that there are strong synergies between the two businesses. Natform recently won its first Victorian contract for a few years with some help from Acrow. On the flipside, Acrow is targeting larger players in NSW formwork through Natform connections. Management also estimates that around half of Natform’s current job pipeline have a client connection to Acrow with the potential for an integrated product offering.

Management has stated that it is open to further acquisitions along with organic growth. We support this trajectory (but will analyse future potential acquisitions as they arise). We see value in Acrow if the firm continues to purchase businesses with synergies at low multiples of EBITDA. These will likely be revalued by the market at Acrow’s EBITDA multiple (currently 3.9X), effectively increasing the market value of the acquisitions. During 1HY19, Acrow made operating cash profit of $5.5m. Debt currently stands at $2.5m (the company has a $15m Westpac facility). At this late point in the business cycle, we would prefer Acrow fund acquisitions through free cashflow rather than through the facility.

Acrow’s roll up strategy is reminiscent of Greencross (GXL:ASX), an operator of vet clinics and pet stores throughout Australia which was recently bought out and delisted. Greencross similarly purchased businesses at low multiples (family-owned pet stores, private vet clinics etc), the cashflows of which were then valued at Greencross’ higher market-applied multiple. This proved to be very lucrative for investors. Of course, roll up strategy alone does not add any value. However, Acrow has indicated that its acquisitions should result in strategic synergies, pulling out pooled costs and promoting integrated product offerings.

Margin Growth
Acrow has achieved a remarkable improvement in EBITDA margin over the last 4 years due to its extensive range of formwork and scaffolding solutions, as well as superior overall service. Acrow is also introducing in-house engineering expertise to increase its service quality and product offering.

Valuation
Acrow is valued as if it is highly leveraged to Australia’s residential construction headwinds. The firm has a 6/2019E free cashflow yield over 20% with estimated double-digit earnings growth over the next two years. A PEG ratio (PE ratio divided by forecast EPS growth) of around 1 is generally viewed as reasonable, while high quality companies or those with defensive cashflows often have a ratio over 1. In comparison, Acrow’s PEG ratio is around 0.5 – an opportunity in a fearful market.

Yield
At Insufficient Capital, we do not particularly care for a dividend yield and almost always prefer our holdings invest their capital rather than return it to shareholders. If suitable investments are unavailable, we would generally prefer our holdings to engage in share buybacks rather than pay a dividend so as to marginally increase our ownership of the company over time.

However, if a holding offers a dividend reinvestment plan (DRIP) at a discount to its recent share price, we will take it up 99% of the time according to Ground Rule* #9. In Acrow’s case, the DRIP is at a 2.5% discount. The annual 6.3% yield represents a very low payout ratio to allow for dividend increases over time (we plan on reinvesting all dividends with the DRIP).

Cooper Energy (COE:ASX)

Cooper is a position which has nearly played out – a great example of a typical investment for the fund. Cooper generates revenue from the discovery, commercialisation and sale of gas to south-east Australia and low-cost Cooper Basin oil production. The company currently produces around 6PJ of gas per annum from the Otway Basin (mostly from the Casino Henry project).

Sole
Cooper purchased the ‘Sole’ gas project from Santos on 1 Jan 2017, and in late 2017 completed a $400m financing round involving $135m of equity and $265m debt, from ANZ bank and Natixis. The Sole gas field will supply 24PJ of gas per annum from June 2019 and has a growing portfolio of take-or-pay gas supply contracts, with customers including AGL Energy, Alinta Energy, Energy Australia and O-I Australia. These contracts reduce Cooper’s exposure to future gas price volatility (although we expect gas prices to increase, we still prefer to reduce exposure to commodity price risk). The project was 98% complete as at 31 March 2019 with capital expenditure incurred on the project to that date by the company totalling $314m. Below represents the increase from 6PJ (at Casino Henry) in 2019 to around 30PJ (upon commencement at Sole) throughout the 2020s.

Manta
There is also considerable upside with the development of Cooper’s Manta project which would nearly double production from FY2024. Although there would be financing costs accrued, the lion’s share of value would accrue to existing shareholders.

Domestic Gas Pricing
As gas prices are higher overseas, there is likely to be a shortage in the populous eastern states. Most gas is converted from coal seam gas and exported as LNG. At the time of project approval, the government rejected proposals that mandated a proportion of gas to be sold domestically. Cheap gas produced in Victoria is now being diverted to Queensland, where it is sold at a premium offshore. Currently, two thirds of gas produced is sold offshore. There is limited pipeline competition which adds further barriers to a competitive local gas market. This supports domestic gas prices with demand far outstripping supply. Even though Cooper is protected from gas price risk by its take-or-pay contracts over the majority of future production, it is a pleasant bonus that prices for uncontracted gas are supported by a strong imbalance between demand and supply.

Valuation
When we entered the position, Cooper had a market capitalisation of $470m and a significant cash position. This cash has now been depleted to finance the development of Sole while the market capitalisation has risen to $867m. 2020 EBITDA is forecast to be $178m (up from $37m in 2019). At purchase, Cooper had a 2020 forward EV/EBITDA of under 2X. This multiple has since risen to 4.8X.

Since Cooper will likely continue to achieve EBITDA of around $180m throughout most of the 2020s (excluding any potential contribution from Manta), we expect the market to value Cooper at a utility-like 8-10X EBITDA, which would imply a further 1.7-2X increase in value. Few investors are willing to invest on three-five-year time frames for future earnings potential. Some examples of comparable past investment opportunities would be Beach Energy and Oil Search pre-production. Insufficient Capital took on Cooper’s development risk and has been rewarded, however we believe there will be further rewards for investors who wait until the market fully appreciates annuity-style earnings. We will review and potentially exit the position once earnings begin to flow from Sole later in 2019.

Quip of the Month

“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative” (Benjamin Graham – The Intelligent Investor).

When reviewing our investments in Cooper and Acrow, Graham’s emphasis on the conditions for investment over speculation came to mind. When investing, we look at the business qualitatively before estimating future cashflows and then discounting them. Short-term fluctuations in valuation are irrelevant to our investment style.

We are confident in the long-term safety of Acrow as infrastructure spending grows with the Australian economy, while the firm’s valuation at a low multiple of cashflows supports an (hopefully) adequate return. Although it is generally risky to expose oneself to the Australian economy, we believe Acrow’s downside risks are on balance outweighed by the upside potential presented by a low valuation.

If subscribers would like further details on Acrow Formwork and Cooper Energy, we are more than happy to answer any questions.

Kind Regards,
Insufficient Capital

A Change in Our Reporting

Going forward, we will only report performance when we deem it to be significant to the fund. We will report industry weightings quarterly. At the end of the June quarter, our portfolio was most heavily weighted to Australia’s energy industry (particularly towards coal and natural gas):

On a monthly basis, we will report net equities exposure, the largest contributor, the largest detractor, monthly ASX300 performance and any key changes to the portfolio. At June end, net equities exposure was 87%. The largest contributor was Stanmore Coal, while the largest detractor was Aurelia Metals. The ASX300 appreciated 3.41% over June. We generally like to hold a minimal cash position (See investing Ground Rule* #10) due to the long term powers of capitalism but believe current market and economic conditions present an extremely challenging environment to achieve our desired annual return target (See investing Ground Rule* #12) without taking on excessive risk. We believe that future opportunities will yield better risk/return profiles.

As a high conviction fund, Insufficient Capital has a more volatile return profile than the benchmark due to its larger position sizes. We stress that high volatility does not indicate that the fund is taking on excessive risk. Abstaining from monthly performance reporting will ensure that the fund’s long-term positioning is not misrepresented. We do not engage in proprietary trading or other short-term strategies.

Afterpay Touch Group (APT:ASX)

Our long-term position in buy now, pay later juggernaut, Afterpay (APT:ASX), recently corrected 25% over compliance fears after Austrac ordered the appointment of an external auditor to assess its AML/CTF compliance. We believe this was an overreaction since the mere appointment of an external auditor should not result in a more than $1.5B destruction of firm value. This significantly impacted our performance over the short term (the stock has since recovered around 20%).

More recently, Visa’s announcement of a set of tools and APIs for card issuers and merchants to establish instalment solutions sent the company down 15% in under two hours on the last day of the financial year. Bizarrely, the release from Visa surfaced before the ASX opened and Afterpay was up. We are glad to see such inefficiencies in the market! Visa’s unique position ‘upstream’ in the payment ecosystem from Afterpay puts it in a powerful position to grow quickly and fairly seamlessly. Our take on this development is that whilst Visa could dominate Afterpay on a global offering, Afterpay retains the first mover advantage in the way that these are merely a set of tools to create an instalment service. Visa’s business model has historically been to take on limited credit risk (much like that of Mastercard). Visa does not issue lending products, purely offering the back end for their partners. There has been nothing to indicate that this will change in the short term. Consequently, the risk would have to be taken on by the merchants (unlikely) or the card issuers, who presently make the majority of their money from interest and a smaller amount from interchange fees – while transaction/network fees are the largest revenue source for Afterpay/Visa. Nonetheless, we will be watching this development closely as widespread adoption does have the ability to jeopardise Afterpay’s offering. We believe Afterpay’s first mover advantage, as well as the necessity for card issuers to alter their business models, make it safe – for now.

Stanmore Coal (SMR:ASX)

We have continued to build a position in Stanmore Coal over the last year and it is now the fund’s largest holding. Stanmore owns the Isaac Plains mine, a metallurgical (also known as coking) coal mine with significant mine life (over 15 years) located in Queensland’s premier coal region, the Bowen Basin. In addition, a small amount of thermal coal is produced from the project. Mining is currently at a rate of 2.9Mtpa, with the product being exported to key customers in the steel manufacturing industry. Exposure to China’s slowing economic growth or political chess is a minimal threat to Stanmore’s earnings since around half of Stanmore’ customers are in Korea and Japan, while Europe and India represent most of the remaining bulk of the customer base:

As an aside, it should be noted that we believe China’s impact on the Australian coal market, whilst significant, is not as significant as commonly portrayed – Japan imported 50% more Australian coal (preferred for its relatively low ash content) than China in 2017.

Isaac Plains East Project
Stanmore acquired Isaac Plains East in 2015. There are significant synergies through the acquisition since the project can use Isaac Plains’ CHPP and rail network rather than engaging in capital expenditure. Operations commenced in June 2018.

Other Mining/Exploration Opportunities
Isaac Downs was acquired in 2018, with consenting and approvals underway. Isaac Plains South is in exploration phase. Stanmore also has a portfolio of over 2,000km2 of exploration tenements in the Bowen Basin and Surat Basin, as well as 2 JVs with coal junior, Bowen Coking Coal (ASX:BCB).

Coking Coal – The Evil(?) Elephant in the Room
Recently, some of our team attended an Australasian Institute of Mining and Metallurgy (AusIMM) panel event with the topic “Does coal have an image problem?” – The answer, supported by numerous Australian media houses, a resounding “Yes”. It is astounding to note that the majority of the Australian public relates coal solely to power generation. However, there are two types of coal:

1. Steam/Thermal Coal (mostly used in power generation)
2. Coking/Metallurgical Coal (higher grade coal, used in steel production)

While the great majority of Australians hope there will be cleaner power generation in future, most (Insufficient Capital’s management included) also see steel production as a future necessity in a continually developing world. Since steel production will remain crucial until there is a foreseeable replacement for the product, Insufficient Capital will continue to evaluate metallurgical coal opportunities.

A key takeaway from the AusIMM panel event was the difficulty in financing new coal projects. Australian banks and other lenders are shying away from lending to coal firms (pressured by the public spotlight on coal). Future projects are much more likely to be financed through retained earnings and private/offshore capital rather than through debt financing. Stanmore is in an enviable position, well-prepared to fund future projects through its retained earnings. Net cash increased to $58.4M (market capitalisation $353M, no debt) through the March quarter. The firm also recently instigated an on-market share buy-back of up to 10% of stock.

Coal Price Risk?
Many funds choose to shy away from any exposure to commodity price risk. We do not pretend to be experts in commodity price movements (or more specifically, the individual factors which affect a commodity’s demand and supply). We also acknowledge that the largest lever for Stanmore’s performance is completely out of our control. However, there are three key factors which alleviate the vicissitudes of metallurgical coal prices:

1. High Margin: Stanmore has low FOB costs of $88/tonne and a high margin, translating to expected underlying EBITDA of $140-$155M for FY2019. Stanmore’s FOB cost has also fallen around 10% since Q1 FY2019 as the company achieved further synergies through the Isaac Plains East project. We are confident that there is enough margin in Stanmore’s production to weather a significant drop in metallurgical coal prices.
2. Valuation: We will discuss Stanmore’s valuation later on in the newsletter. We are content to have metallurgical coal price risk mitigated by a valuation 40% below industry peers similarly exposed to the commodity’s price risk.
3. Strong Balance Sheet: At the end of Q3 FY2019, Stanmore had $58.4M net cash. This cash will likely be deployed when coal prices are lower as greater opportunities prevail. The firm’s fiscal conservatism reflects the views of the experienced management team. We have entrusted our capital to a proven team who have expertly negotiated coal price movements throughout the business cycle in their prior roles.

Management
Insufficient Capital strongly backs operationally focussed management, particularly in the resources sector where it can be make or break for the firm’s longevity. As a result, it is no secret that we are huge fans of Stanmore’s management and board, awash with former Glencore Coal, Rio Tinto and Wesfarmers Resources leadership. In particular, it is very reassuring to see three ex-Glencore employees on Stanmore’s four-person leadership team:
Dan Clifford (Managing Director) – Former GM of Glencore’s Ulan Coal, Bernie O’Neill (General Manager Operations) – Former GM of Glencore’s Newlands/Collinsville Coal, Jon Romcke (General Manager Development) – Former Head of Iron Ore assets for Glencore International.

Dividend Reinvestment Plan (DRIP)
In April, Stanmore paid a 3c/share interim dividend, reflecting an annualised yield at the time of around 5%. We believe that the firm’s dividend yield will increase over time through greater future cashflows coupled with 10% fewer shares on the registry (if the 10% buy-back is completed). Stanmore offers a dividend reinvestment plan at a very attractive 5% discount to the VWAP over the short period following the ex-dividend date. We took part in the last DRIP according to our investment ground rules (See investing Ground Rule* #9), a lucrative decision for the fund. Shares received in the DRIP have since appreciated over 30%.

Valuation
Stanmore Coal has experienced management, low production cost and superb future opportunities. However, the firm trades at 2.3X EBITDA, a 40% discount to some of its larger peers. We believe Stanmore should be trading at 4X EV/EBITDA due to its strong cashflow generation, operational expertise and consistent upgrades to mine development.

Quip of the Month

Liam Twigger, PCF Capital Group MD, said of M&A activity:
“Too many companies are looking for a Brad Pitt when in the right circumstances, they might be able to settle for a Bart Simpson.”

At Insufficient Capital, we do not strive to relate pop culture to investment theory. However, Liam’s argument rings extraordinarily true, particularly in relation to the energy industry. Stanmore bought Isaac Plains (then a mothballed, unwanted mine) for all of $1 from Vale and Sumitomo. Rather than searching for an expensive acquisition with a lower risk profile (Brad Pitt), Stanmore took on the challenge of an unloved asset (Bart Simpson), striving to make it work by applying experienced management. If we were to take this metaphor further, we’d say that Stanmore’s management are comparable to Steven Spielberg, a director who could generate great results from Bart. In time, we will see what Spielberg has in store for Stanmore.

Liam’s remark relates to a core dilemma of value investing – Should we pay a fair price for a great opportunity or a great price for a fair opportunity? Warren Buffet argues the former. However, Stanmore clearly observed the latter. Insufficient Capital has a rather unhelpful, on the fence belief, that each opportunity requires case by case analysis. We are happy to follow either school of thought.

If subscribers would like further details on our activities, we are always happy to discuss portfolio positions.

Kind Regards,
Insufficient Capital

The fund rose +3.73% over the August reporting period, compared to the ASX300 performance of -2.97% (+6.7% outperformance). At August end, the fund held 27% cash. The top contributor was Afterpay, while the largest detractor was Acrow Formwork.

Positioning Changes

We recently exited a long-term core position in natural gas producer, Cooper Energy (COE:ASX). We bought Cooper in late 2017 at 2.2X 2021 forecast EV/EBITDA. There are four key risk areas to investing in energy: Funding, Exploring, Extracting, Selling. When we invested, Cooper had already completed all required funding and exploration. The firm had take-or-pay contracts with AGL Energy, Alinta and Energy Australia on the vast majority of future production throughout the 2020s. This significantly reduced natural gas price risk (Selling Risk). The only remaining major risk associated with Cooper was extraction (the physical process of laying pipe and transporting natural gas). We did not believe that a 2.2X forward multiple (albeit, 3 years out) was appropriate for Cooper’s risk profile given comparable firms are valued at around 5-6X forward EBITDA. We believed that what appeared to be short-term thinking investors would only appreciate Cooper’s cashflows when they begin occurring in 2021. Pleasantly, Cooper’s multiple has expanded earlier than expected. This reduced our expected return below the return target set out in our investing Ground Rules, prompting the decision to exit the position at a 91% profit.

We added 20% to our Afterpay position after a meaningful pull-back provided the opportunity prior to its reporting. In addition, we added 20% to our Stanmore position after a similar pull-back. We also initiated a small position in card-issuer and platform, EML Payments. Further details regarding the results of the three will be detailed below.

Stanmore Coal (SMR:ASX)

Details about our investment in Stanmore Coal can be found in a previous newsletter. The company is our largest position. Stanmore received a non-binding, indicative proposal from Winfield (a private group with experience in the Bowen Basin via a shareholding in Glencore’s Rolleston mine) for between $1.50 and $1.70/share. Winfield’s 4 week due diligence period is due to end imminently. This comes after a $0.95 offer from Golden Investments in November 2018. We continue to hold the position and believe there could be competing offers in future due to Stanmore’s high quality of assets.

Annual results were presented on 22 August:

The company announced a final 8c/share dividend, taking the full year dividend to 11c/share). This represents a 7.9% yield. We decided to reinvest the 3cps interim dividend earlier in the year, following Ground Rule * #9. This proved to be a very lucrative decision for the fund. Unfortunately, Stanmore is not offering a reinvestment plan for the final dividend.

Despite the company’s superb performance, Stanmore continues to trade at 2.4X forward EBITDA, a 40% discount to some of its larger peers. We believe Stanmore should also be trading at 4X forward EV/EBITDA due to its strong cashflow generation, asset quality, operational expertise, deleveraged balance sheet (SMR’s cash position is now 25% of its market capitalisation) and consistent upgrades to mine development.

A valuation of 4X forward EV/EBITDA would be significantly higher than the upper bound of Winfield’s offer.

EML Payments (EML:ASX)

We initiated a position in EML during the month, seeing great opportunity in its prepaid stored value products. EML is a principle member of MasterCard in Australia and Europe, processing and authorising card transactions across 21 countries on MasterCard, Visa, Discover and Eftpos.

Whilst EML faces strong competition from US payments heavyweight Stripe (who are rolling out an issuing API [a set of tools for building software applications] which is heavily discounted), we still believe there is midterm upside for EML. EML is valued far more cheaply than other financial services firms at 25X EV/EBITDA, growing topline revenue by 37% during FY19 and EBITDA by 38%. The company is well-positioned for further investment in its engineering team (a key weakness vs the new breed of fintechs) with $18.1M of net cash.

The investment has appreciated +25% since our initiation. We will update our subscribers with more details on EML in a future newsletter which will follow our usual format.

Afterpay Touch (APT:ASX)

We first invested in Afterpay at a $1.3B valuation (EV/Sales circa 40). The company is now worth over $8B (EV/Sales of 23.2) but is around 2X cheaper based on EV/Sales multiple. Despite the incredible appreciation, we believe the company now carries less risk than at our first entry due to its foothold and scalability in Australia and the US. There has also been strong initial growth in the UK, with over 200,000 customers onboarded in the first 15 weeks:

Annual results were presented on 28 August:

Gross losses as a proportion of income should continue to fall in future since Afterpay’s algorithm locks out any customer who fails to pay on time from future purchases. This will boost future profitability and reduce exposure to credit risk.

Afterpay remains on track to deliver on its mission to be the world’s most loved ‘buy now pay later’ platform. We found one statistic particularly compelling. New US customers could be purchasing 5X more frequently in two years if they remain on Afterpay’s platform and follow Australian customer behaviour.

Unlike most funds which reduce positions as they grow, we will only reduce positions when we no longer believe they meet our investing criteria.

Acrow Formwork (ACF:ASX)

Acrow was covered in more detail in a previous newsletter. The company is effectively transitioning from residential scaffolding (a very competitive, cyclical and fragmented market) to value adding civil formwork solutions focusing on infrastructure projects.

Acrow’s annual results were presented on 30 August:

We continue to maintain high conviction in the position as a core holding, despite its poor performance for the fund, and believe it is a superb countercyclical opportunity due to its infrastructure focus. Acrow trades on a PE of <7 and pays a 7.4% dividend. Despite our large position, we will reinvest all dividends if they are offered at a discount to the share price according to Ground Rule * #9.

Acrow invested heavily in its people during FY2019. We are excited to see continued development of in-house engineering expertise, which could be a lucrative revenue stream for the business. Acrow also revealed it was in negotiations to acquire Unispan, a highly complementary business – we expect multiple synergies to be realised should the transaction occur. Similar to the Natform acquisition at around 2X EBITDA, Unispan would likely be purchased at a low multiple of earnings through debt funding.

Aurelia Metals (AMI:ASX)

We entered Aurelia due to its attractive cost of production, diverse base metal production and healthy balance sheet. Aurelia follows our 1st Ground Rule *, with a large cash balance available to fund further exploration and development. Since our first entry, the company has faced a number of shocks:

• Blowout AISC cost of production (doubling to $1,045/oz in 2019 from $509/oz in 2018)
• Exit of Glencore from register and failed transaction to buy Glencore’s CSA mine
• Departure of a respected CEO over unclear reasons
• Increasing concerns over remaining quality and life of assets

Despite these shocks, the company has a very strong balance sheet with $104 million cash (just under 25% of its market capitalisation) – more than enough to fund further exploration around the Federation project and future capex for mine development and upgrades. Furthermore, the company’s base metal mix is attractive (our views are in line with Glencore’s regarding the future demand/supply conditions for zinc and copper), with the Pb/Zn circuit upgrade, as well as the mining shifting to a more base metal rich area, expected to boost these outputs.

We believe the market has overreacted to Aurelia’s shocks over the last year and that the company has now made a fresh start. Although Aurelia has indicated that its outlook is rather positive due to its base metal mix, the company continues to trade at a low forward EV/EBITDA of 2.9X.

Aurelia declared a maiden dividend (2c/share), delivering a 4% yield. Returning capital to shareholders will have a minor impact on Aurelia’s significant cash position. We are excited to see Aurelia continue to develop itself as a mid tier gold and base metal producer.

Quip of the Month

“All you need for a lifetime of successful investing is a few big winners, and the pluses from those will overwhelm the minuses from the stocks that don’t work out.” – Peter Lynch

Lynch achieved a return of 29.2%/annum for Fidelity Investments between 1977 and 1990.

One of the many struggles that fund managers encounter is the pressure to sell positions as they grow to reduce volatility and short-term downside risk. This has become more relevant recently, particularly in relation to our growing positions in Stanmore Coal and Afterpay. The tendency to trim positions is much more common when managers deploy outsiders’ capital (rather than only their own capital). Following the common practice of trimming positions makes it very difficult to follow Peter Lynch’s advice since big winners which are continually trimmed will never be allowed to grow to their full potential. Although Insufficient Capital only manages the capital of its team, we hope that taking on outside capital in future would never result in portfolio trimming for any reason other than investment quality.

Australian REITs

At Insufficient Capital, we do not profess to own a macroeconomic crystal ball. We focus entirely on the company level. This means that we often fail to discover companies which follow macroeconomic trends unless they meet our other investing criteria. However, we recently researched one of the most lucrative recent macroeconomic trends – the ‘yield play’, whereby the falling cash rate results in huge capital flow from bank deposits to other yielding assets, particularly property, resulting in yield compression.

The A-Reit Index (Australian Real Estate Investment Trusts are its constituents) appreciated around 14% (excluding dividends) during FY2019, outperforming the broader ASX200 by over 7%. Australian REITS have had their prices pushed up further and further by capital inflow hunting for yield, particularly from superannuation funds. While there will likely be further upside if rates fall to the lower bound of 0%, we caution that the Australian economy would be in a poor position (with diminishing consumer spending and investment) to warrant further RBA cuts to 0% (however, the RBA has indicated that further cuts are quite likely). Investing in property as a bond proxy is great when cash rates fall… until tenants can’t pay their rent.

In saying that, some of our subscribers have reached out to us asking which property trusts present the best value. We believe BWP Trust (BWP:ASX) and Charter Hall Long Wale Reit (CLW:ASX) best mitigate the key risks associated with a (potentially) deteriorating economy. BWP was spun out of Wesfarmers (the owner of Bunnings) in 1998 as a sale and lease-back. BWP owns 265 stores leased to Bunnings nationwide. The trust yields 4.75% and has returned 15.5%/annum in the last 10 years. The portfolio WALE is reasonable at 4.4 years and gearing is low at 17.3%. Wesfarmers owns 25% of the trust. BWP offers investors a yield which is superior to any deposit rate without exposure to economic vicissitudes due to the defensiveness of its major tenant. Charter Hall Long WALE appears to be the most attractive REIT available on the ASX when considering the ‘yield play’ because it most resembles a long duration bond. CLW’s WALE is 12.5 years, with 91% of tenants being government-associated or ASX-listed. The REIT yields 5.2%. During August, CLW announced that they would buy a portfolio of Telstra assets on a 4.4% yield. This transaction represents around 18% of its market capitalisation. We believe that CLW’s total yield could easily compress to around 4.4%, representing 15% capital upside.

If subscribers would like further details on our portfolio positions and strategies, we are always happy to discuss.

Kind Regards,
Insufficient Capital

At the end of the September quarter, the fund was most heavily weighted to our ‘Net Cash Miners’ strategy:

The portfolio rose +9.25% over the quarter, strongly outperforming the ASX300 performance of +1.24% by +8.01%. We were very pleased to record outperformance over each month, most notably in August – a great start to FY2020. The top contributor during September was Afterpay (APT:ASX), while the largest detractor was Acrow Formwork (ACF:ASX).

Despite our tilt to value opportunities, most of our portfolio appreciation has recently been caused by growth investments (the majority fall under the ‘Structural Tailwinds’ strategy). We believe this has been caused by a momentum-loving, growth-hungry domestic equities environment, which seems ever more willing to disregard valuation for hockey-stick growth. In fact, Australian stocks with EPS growth greater than 20%/annum trade at double the valuation multiples of similar stocks listed overseas. We are confident that our value investments will have their time in the sun again (especially if economic conditions deteriorate).

At quarter end, the fund held 23% cash. The fund held an average cash position >25% during the quarter. This cash position greatly reduced our volatility and leaves further room for capital deployment. As we reiterated in our August newsletter, the fund generally refrains from holding large cash reserves (See Ground Rule #10) but we believe current market and economic conditions present a challenging environment to achieve our desired return target (See Ground Rule #12) without taking on excessive risk. 

During September, we initiated a small position in online sports betting company, Pointsbet (PBH:ASX). Pointsbet offers an innovative betting format known as “Spread Betting”, where winnings/losses are not fixed, instead depending on the accuracy of your bet (e.g. the bettor will win more if their team wins by a larger margin). Pointsbet recently entered the US market, starting with New Jersey, where recent sports betting legislation provides structural tailwinds to the industry. Google search traffic for Pointsbet in the US has more than doubled from August to September, while revenue is tracking at >240% YOY.

Similar to Afterpay and other Australian companies enjoying US tailwinds, Pointsbet is clearly gaining traction with American consumers and will be able to achieve strong lifetime value in future (let’s ignore the bottom line for now!). Pleasingly, our investment has already appreciated substantially and we look forward to further positive catalysts throughout FY2020 as Pointsbet continues its expansion into other US states (starting with Illinois, Indiana, Iowa and West Virginia). With 42 states having legalised, or intending to legalise sports betting, we anticipate a massive market prime for Pointsbet to exploit. We will discuss Pointsbet in depth in a future newsletter.

Rather than presenting a single stock idea, this newsletter will focus on a broader investment strategy – Buying Listed Investment Companies (LICs) at a Discount to Net Tangible Assets (NTA). Our management team regularly attends fund presentations as part of our internal research. Some of these funds are traded publicly (often as LICs) while others are private. It has become clear that some LICs are mispriced due to a few factors. After establishing the factors behind their discounts to NTA, this letter will set out the buy case for heavily discounted LICs using the example of a LIC we have previously owned and continue to find attractive.

Listed Investment Companies are closed-end public investment vehicles. Since they raise capital at IPO and investors buy/sell shares to each other, capital is permanent, removing the risk of redemptions. Further details on LICs can be found here. The largest LICs in Australia include Australian Foundation Investment Company (AFI:ASX), Argo Investments (ARG:ASX), Milton Corporation (MLT:ASX), Magellan Global Trust (MGG:ASX) and WAM Capital (WAM:ASX). 

Buy High Sell Low? Hmmm

LICs have the extra consideration of premia and discounts to NTA. For example, if a LIC raises $100M at $1/share (NTA/share) but is trading at <$1/share, the LIC is at a discount to its NTA (i.e. if its investments were liquidated and distributed to shareholders, shareholders would realise an immediate gain); when the LIC is trading at >$1/share, the LIC is at a premium to its NTA. 

Investor psychoanalysis reveals that most investors do the exact opposite of the famous adage, “Buy Low Sell High”. A very reliable cycle of emotions has dominated financial markets since the first pieces of stock paper were flying around in 16th Century England. This cycle of emotions has remained predictable ever since: Greed, Fear, Greed, Fear. There would be a lot less money to be made in markets if all investors adhered to Warren Buffet’s perhaps most famous adage: “Be fearful when others are greedy and greedy when others are fearful”. 

When investors in a LIC panic and fear poor future performance (of either the market, the LIC, or both), they exit their positions, potentially pushing the price of the LIC below NTA/share. We find this particularly astounding when LICs have large cash weightings in their portfolio. Imagine if the bank valued your savings account at 80c in the dollar! A fund manager (whose presentation we recently attended) said that no matter what, “People will always sell at a discount and buy at a premium (to NTA)”.

Current Investor Confidence

It is hard to read a financial paper without facing another article about Australia’s imminent recession. It is also becoming increasingly normal to wake up to >2% movements in US markets. Such pessimism and volatility contribute to capital outflow from LICs into lower risk investments (e.g. passive index funds, term deposits).

Investors also have increasingly distrusted expensive actively managed funds over low-cost passive index funds. With increased competition between passive funds and active managers, the days of a 2 and 20 fee structure (2% management fee and 20% performance fee) appear numbered. The underperformance (which is obviously not helped by high fees eroding gross performance) of active managers is more concerning. 

Since the GFC, a whopping 85.1% of actively managed funds have underperformed the S&P500 while 91.6% have underperformed over a 15 year period. There is no doubt that such widespread underperformance has contributed to discounts across the entire actively managed LIC space (even if all LICs cannot be painted with the same broad scathing brush). It has been difficult to outperform in the US without owning the famed FAANG stocks (Facebook, Apple, Amazon, Netflix and Google). They have now collectively grown to represent 35.3% of the Nasdaq100. Australia shares similarities with the WAAAX stocks (Wisetech, Afterpay, Appen, Altium and Xero), although these firms do not represent a large proportion of the index.

In 2008, Warren Buffett (our not so secret crush), made a $1M bet with fund-of-funds, Protege Partners, that an equally weighted group of 5 actively managed funds hand-picked by Protege would underperform the S&P500 (VFIAX – a 0.04% cost index fund tracking the S&P500) over a 10 year period due to the fees, costs and expenses associated with active management. 

By 2015, Protege co-founder, Tim Seides, acknowledged two years before the scheduled end date of the bet that “for all intents and purposes, the game is over. I lost.” By 2016, the index fund had returned 85.4% while the 5 funds had returned a comparatively dismal 22%. The result – Buffet’s chosen charity, Girls Incorporated of Omaha, had an extra $1M… and a crushing defeat for actively managed funds:

Underperformance >> devaluation of management expertise >> magnified discount to NTA

Liquidity & Risk Discounts

Some LICs (particularly those with <$100M of AUM) have little to no daily volume for extended periods. Such LICs should be discounted by at least the average buy/sell spread. If you have to take a 5% haircut just to exit a position, such illiquidity should be priced in

There are also quite a few of what we like to call, ‘YOLO (You Only Live Once) Opportunities’, out there. These funds take on excessive risk, sometimes even using internal leverage, or speculating on opportunistic mining explorers. Their discounts are justified. As an aside, some of these ‘YOLO Opportunities’ LICs have quite amusing names (perhaps inspiring our very own ‘Insufficient Capital’). Our personal favourite is “Fat Prophets Global Contrarian Fund” (ASX:FPC – Yes, it is real) – its discount, a whopping -24%. Buying high beta is all fun and games when the market is rising… until the market isn’t.

The Buy Case

If a LIC aligns with an investor’s personal strategy, sells at a discount, has reasonable fees and a reliable track record of creating investor value, it could definitely serve a place in a portfolio. If purchased, investors need to stay on top of the LIC’s major portfolio positions and its discount to NTA over time.

One of the greatest risks after purchasing a LIC is that an investor will become complacent and fail to update their research as the portfolio changes over time. Unlike an individual business, the thesis for a LIC must be updated regularly (usually on a monthly basis). We would never hold a LIC that trades at a premium to NTA.

Cadence Capital 

One of the LICs we have previously owned is Cadence Capital (ASX:CDM). Over the last 14 years (since inception), CDM has returned +11.7%/annum after fees and including dividend franking credits (outperforming the All Ords by +3.1%/annum). This is a cumulative return of +355.6% vs +211.5% (as at June 30).  We have kept on top of their portfolio ever since our investment and share the value-driven strategy of the portfolio manager, Karl Siegling. We even share some past and present positions: Stanmore Coal, Bingo Industries, Shine Corporate, Select Harvests, Westpac Banking Corporation, Telstra Corporation

Cadence currently trades at a very high 22.7% discount to NTA post tax obligations. This is particularly astounding considering the LIC’s 32.6% cash weighting (as at 30 September)… So CDM’s riskless cash at bank is being discounted to less than 80c in the dollar. Just to put that in perspective – if we buy CDM, which has around 2% of its assets in Stanmore Coal (our own largest holding), we are effectively paying 87.3c (22.7% less than the current market price of $1.13/share) for the Stanmore stock. This would be a PE ratio of 2.4X and a dividend yield of 14.9%. Or we could buy it in the market at 4X and 11.5% (both are cheap nonetheless).

The market is clearly expecting Cadence’s significant cash weighting to be allocated terribly. Looking at Cadence’s FY2019 performance, it is easy to be forgiven for this belief. Cadence’s net performance was -20.5% during FY2019, while the All Ordinaries appreciated +12.5%. The largest detractors included: ARQ Group, Emeco Holdings, Navigator Global Investments, Shine Corporate and Teva Pharmaceutical. Most notably, ARQ (formerly known as Melbourne IT) collapsed around 90% from its peak in December 2017 to now representing only 2.4% of the fund. Siegling has gone onto the board of ARQ in an attempt to steer the ship. We strongly believe that he is doing everything in his power to recover value for all ARQ shareholders.

At the annual roadshow, it was clear that Cadence’s board is desperately trying to close the discount to NTA. The LIC has undertaken a buyback of approximately 10% of its stock, immediately accreting value to shareholders. Additionally, the portfolio manager is buying stock almost daily and reinvesting dividends. 

Until October 2018, Cadence had traded at a premium during the vast majority of the past 5 years. The LIC even reached a 20% premium in 2016. In the depths of the GFC, it reached a 40% discount. We believe that only another recessionary period could warrant such an extreme valuation dislocation.

We are particularly attracted to Cadence’s positions in Macquarie Group (4.9% of the LIC’s assets), Resimac Group (4.1%), Rio Tinto (1.9%), Stanmore Coal (1.8%) and BHP (1.6%). That’s not to say our team is attracted to all of Cadence’s positions, with a handful raising concerns. Nonetheless, we continue to evaluate Cadence’s portfolio and would not be surprised if it became a future position of ours. Ideally, we would first like to see the deployment of some of its large cash position.

Quip of the Month

“The time to buy is when there’s blood in the streets” – Baron Rothschild

Rothschild made a fortune in the panic that followed England’s victory at the Battle of Waterloo against Napoleon. Using a network of agents across Europe, Rothschild learnt of Wellington’s victory on June 18 1815, before other investors. He heavily sold British stocks and pound sterling, with the other investors following suit, effectively creating an environment of spilt blood. Later that day, Rothschild bought all of it back before the news emerged publicly and the market surged. This sequence of events is also said to be the source of the maxim, “Buy on the sound of cannons, sell on the sound of trumpets.”

Buying a discounted LIC is a contrarian investment, epitomising the notion of investing after ‘blood’ (losses) has been shed. Another great example of contrarian investing would be the purchase of Bingo Industries (ASX:BIN) on 18 February 2019 (the stock’s all time low) when concerns regarding stagnating growth for the waste management giant were echoing throughout Sydney’s Martin Place. Despite this, some contrarian investors recognised a sound underlying business facing short term headwinds. They realised a >100% return in 4 months.

If subscribers would like further details on our activities, we are always happy to discuss portfolio positions.

Kind Regards,
Insufficient Capital